Inflation outlook volatile, BoE warns

UK inflation will be “unusually volatile” in the coming months and could fall below 1% in the autumn, the Bank of England said in its quarterly inflation report today.

In the short term, the bank anticipated that inflation will drop well below its 2% target, reaching as low as 1% later in the year, but added that it was uncertain how slack in the economy, the strength of sterling and commodity prices would affect it.

The margin of spare capacity (the difference between potential output and actual output) in the economy is likely to continue to grow for some while yet, bearing down on inflation in the medium term, the bank warned. However, this could be offset by the impact of sterling’s depreciation on consumer prices in the near term. Rising global energy prices may also exert upwards pressure on inflation.

Among the bank’s Monetary Policy Committee there are a range of views on the relative strengths of these factors, the bank said. In addition, having committed an extra £50 billion to its asset purchase facility, or ‘quantitative easing’, on August 6, the bank said it was “difficult to predict with precision the impact of the asset purchase programme on nominal spending and inflation”.

The bank’s governor, Mervyn King, warned that while asset purchases may boost the supply of money to the economy, increased bank lending is not an inevitable result of quantitative easing. “It will take time for banks to repair their balance sheets, and they face considerable challenges in replacing those sources of funding that dried up in the financial crisis and the temporary support provided by the public sector.”

Overall, the report maintained that banks’ funding conditions have improved in recent months, and that there has been some stabilisation in their finances. But they will need to replace a significant amount of funding that is due to mature in the coming years, including government aid. In addition, the increased regulatory emphasis on capital adequacy may be pushing up funding costs, the bank said.

However, even if credit availability does improve, spending could be curtailed by households choosing to save more, the bank warned.

In a scenario where the bank rate is held at 0.5% and the stock of purchased assets under the government’s quantitative easing programme reaches £175 billion, the chances of inflation being above or below the 2% target by 2011 are “broadly balanced”. However, the bank asserted that its drive to maintain inflation close to target could see inflation rise.

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